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Learning Objectives

5 chapter

Introduction to Financial

Statement Analysis

1Explain the purpose

of financial statement analysis.

2Understand the rela-

tionships between finan- cial statement numbers and use ratios in analyz- ing and describing a com- pany's performance.

3Use common-size fi-

nancial statements to per- form comparison of financial statements across years and between com- panies.

4Understand the

DuPont framework and

how return on equity can be decomposed into its profitability, efficiency, and leverage components.

5Use cash flow infor-

mation to evaluate cash flow ratios.

6Understand the limita-

tions of financial statement analysis.After studying this chapter, you should be able to:

© 2003 Getty Images

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In 1987, IBMwas the most valuable company in the

world, worth an estimated $105.8 billion. By the end of 1992, IBM had an estimated value of $28.8 billion. This decline in value can be traced to a strategic error made by IBM in the early 1980s. Prior to 1981, IBM was the major player in the computer market and was the primary provider of computers for government, univer- sities, and businesses. At this time, believe it or not, virtually no computers were available at an affordable price for individuals. Then, in 1981, IBM introduced its personal computer (IBM PC), and it quickly established the standard by which other PCs would be measured. However, IBM elected to leave the software develop- ment for PCs to other companies. Instead of develop- ing its own disk operating system (DOS), IBM elected to use a DOS developed by a small company located in

Seattle - MICROSOFT.

1

Microsoft was founded in 1975 by Bill Gates and

Paul Allen.

2

When they founded Microsoft, Gates and

Allen envisioned that computers would eventually find their way into everyday life (contrary to IBM's predic- tion in the 1950s when one IBM executive forecast the total worldwide demand for computers to be about five). While IBM's performance floundered in the mid- and late-1980s, Microsoft demonstrated an amazing ability to become a major player in practically every aspect of the computer software market - from operating systems to the Internet to networks to spreadsheets and word processors.

With Microsoft's many accomplishments comes the

question: "Just how successful is the company?" The answer to that question depends on how you define "success." Measured in terms of number of employees, Microsoft has grown from just 32 employees in 1981 when IBM elected to use Microsoft's DOS to 50,500 as of the June 30, 2002, fiscal year. In terms of social im- pact, Microsoft and its employees donate millions of dollars each year to such charitable causes as Special Olympics, Boys and Girls Clubs, and the United Negro

College Fund. Microsoft also supports elementary andhigh schools throughout the country in their efforts to

incorporate technology into the curriculum, and the company has established scholarship programs to en- courage minorities and women to pursue careers in com- puter science and related technical fields. In addition, Bill Gates and his wife Melinda have started a founda- tion dedicated primarily to health and education. Thus far they have contributed several billion dollars to their foundation. In terms of stock price, Microsoft's per-share stock price (adjusted for stock splits) has gone from $0.10 in

1986 to almost $26 in April of 2003 (see Exhibit 1). But

as the graph illustrates, Microsoft's stock price is down from its historic high of over $58 per share in 1999. An analysis of Microsoft's financial statements reveals some of the reasons for the declining stock price. That is the topic of this chapter - an introduction to financial state- ment analysis. With some basic analysis tools (called ra- tios), we will be able to conduct some fundamental analysis of a company's financial statements. Our analy- sis will provide us with insights as to a company's per- formance and will help us identify areas of concern. Keep in mind that this is merely an introduction to financial statement analysis. There are entire textbooks devoted to the analysis of financial statements. Our objective here is to expose you to some of the basic tools to help you start to understand what financial statements can tell us about the operations of a business. To illustrate the analysis techniques introduced in this chapter, we will reference the financial statement of Microsoft in- cluded in Appendix A. chapter 5

Setting the Stage

1 The decision to have another company develop the software for its personal computer was not IBM's only strate-

gic error. At the same time, IBM decided to use another company's microprocessors - the "brains" of the com-

puter. As a result, another successful company was born - INTEL. IBM lost the opportunity to dominate the

software market as well as the computer chip market. By September 2003, Microsoft, Intel, and IBM had mar-

ket values exceeding $317 billion, $187 billion, and $158 billion, respectively.

2 Everybody knows Bill Gates, but few people know about Paul Allen. Allen was Microsoft's head of research

and new product development until 1983 when a serious illness caused him to leave the company. He now

spends much of his time investing in technology companies and watching the Seattle Seahawks, a professional

football team, and the Portland Trailblazers, a professional basketball team, both of which he owns. FYI:

In fact, many people are of the opinion that

Microsoft has succeeded too well. Several of

Microsoft's competitors allege that Microsoft

is involved in monopolistic practices that stifle competition.

66885_c05_202-253.qxd 11/13/03 7:39 PM Page 203

204Part 1Financial Reporting and the Accounting Cycle

Exhibit 1:History of Microsoft's Stock Price per Share 0.00 1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

10.0020.0030.0040.0050.0060.00

The Need for Financial Statement Analysis

Consider the following questions related to financial statement information for MICROSOFT in 2002: •Microsoft's net income in 2002 was $7.829 billion. That seems like a lot, but does it rep- resent a large amount for a company the size of Microsoft? •Total assets for Microsoft at the end of 2002 were $67.646 billion. Given the volume of business that Microsoft does, is this amount of assets too much, too little, or just right? •By the end of 2002, Microsoft's liabilities totaled $15.466 billion. Is this level of debt too much for Microsoft? The important point to recognize is that just having the financial statement numbers is not enough to answer the questions that financial statement users want answered. Without further analysis, the raw numbers themselves don't tell much of a story. Financial statement analysisinvolves the examination of both the relationships among financial statement numbers and the trends in those numbers over time. One purpose of fi- nancial statement analysis is to use the past performance of a company to predict how it will do in the future. Another purpose is to evaluate the performance of a company with an eye toward identifying problem areas. In sum, financial statement analysis is both diagnosis - identifying where a firm has problems - and prognosis - predicting how a firm will perform in the future.1Explain the purpose of financial statement analysis. financial statement analy- sisThe examination of both the relationships among fi- nancial statement numbers and the trends in those num- bers over time.

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Relationships between financial statement amounts are called financial ratios. Net in- come divided by sales, for example, is a financial ratio called return on sales, which tells you how many pennies of profit a company makes on each dollar of sales. The return on sales for Microsoft is 27.6%, meaning that Microsoft makes 28 cents' worth of profit for every dollar of product sold. There are hundreds of different financial ratios, each shedding light on a different aspect of the health of a company. Exhibit 2 illustrates how financial statement analysis fits into the decision cycle of a company's management. Notice that the preparation of the financial statements is just the starting point of the process. After the statements are prepared, they are analyzed using techniques akin to those to be introduced in this chapter. Analysis of the summary information in the financial statements usually doesn't provide detailed answers to management's questions, but it does identify areas in which further data should be gathered. Decisions are then made and implemented, and the accounting system captures the results of these deci- sions so that a new set of financial statements can be prepared. The process then repeats itself. For external users of financial statements, such as investors and creditors, financial statement analysis plays the same role in the decision-making process. Whereas management uses the analysis to help in making operating, investing, and financing decisions, investors and creditors analyze financial statements to decide whether to invest in, or loan money to, a company. In analyzing a company's financial statements, merely computing a list of financial ratios is not enough. Most pieces of information are meaningful only when they can be compared with some benchmark. For example, knowing that Microsoft's return on sales in 2002 was 27.6% tells you a little, but you can evaluate the ratio value much better if you know that Microsoft's return on sales was 29.0% and 41.0% in 2001 and 2000, respectively. In short, the usefulness of financial ratios is greatly enhanced when they are compared with past values and with values for other firms in the same industry.205 Chapter 5Introduction to Financial Statement Analysis FYI:

Financial information is almost always com-

pared to what was reported in the previous year. For example, when Microsoft publicly announced on April 15, 2003, that its quar- terly revenues were $7.84 billion, the press release also stated that this amount repre- sented an 8% increase over the same period in the prior year. FYI:

Financial statement analysis often points to

areas in which additional data must be gath- ered, including details of significant transac- tions, market share information, competitors' plans, and customer demand forecasts. Exhibit 2:The Need for Financial Statement Analysis

Prepare

Financial

statementsAnalyze

Financial

statementsGather

Additional

informationMake

Decisions

Operating Investing FinancingImplement

Decisions and

Observe

Results

lem areas. The informativeness of financial ratios is greatly enhanced when they are compared with past values and with values for other firms in the same industry.TO SUMMARIZE: Financial statement analysis is used to predict a company's future profitability and cash flows from its past performance and to evaluate the perfor- mance of a company with an eye toward identifying prob- financial ratiosRelationships between financial statement amounts.

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Market Efficiency: Can Finan-

cial Statement Analysis Help

You Win in the Stock Market?

An efficient market is one in

which information is reflected rapidly in prices. For example, if the real estate market in a city is efficient, then news of an impending layoff at a major employer in the city should result quickly in lower housing prices because of an anticipated de- crease in demand. The major stock exchanges in the United States often are considered to be efficient

markets in the sense that information about specificcompanies or about the economy in general is reflected almost

immediately in stock prices. One implication of market effi- ciency is that because current stock prices reflect all available information, future movements in stock prices should be un- predictable. It seems clear that capital markets in the United States are efficient in a general sense, but accumulated evidence sug- gests the existence of a number of puzzling "anomalies" in the form of predictability in the pattern of stock returns. For ex- ample, prices tend to continue to drift upward for weeks or months after favorable earnings news is released. In addition, prices continue to climb for at least a year after a stock split is announced. businessenvironment

Widely Used Financial Ratios

Before diving into a comprehensive treatment of financial ratio analysis, we'll first get our feet wet with the most widely used ratios. Familiarity with financial ratios will allow you to hold your own in most casual business conversations and will enable you to understand most ratios used in the popular business press. Data from Microsoft's 2002 financial statements will be used to illustrate the ratio calculations. The data are displayed in Exhibit 3.

Debt Ratio

Comparing the amount of liabilities with the amount of assets indicates the extent to which a company has borrowed money to leverage the owners' investments and increase the size of the company. One frequently used measure of leverage is the debt ratio, computed as total lia-

bilities divided by total assets. An intuitive interpretation of the debt ratio is that it represents

the proportion of borrowed funds used to acquire the company's assets. For Microsoft, the debt ratio is computed as shown on the following page.

2Understand the rela-

tionships between finan- cial statement numbers and use ratios in analyz- ing and describing a com- pany's performance. debt ratioA measure of leverage, computed by divid- ing total liabilities by total assets. Exhibit 3:Selected Financial Data for Microsoft for 2002

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,576*

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,646

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,744

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,466

Stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,180

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,365

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,829

Market value of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293,137

*All numbers are in millions of dollars.

66885_c05_202-253.qxd 11/13/03 7:39 PM Page 206

Debt Ratio: ??22.9%

In other words, Microsoft borrowed 22.9% of the money it needed to buy its assets. Is 22.9% a good or bad debt ratio, or is it impossible to tell? If you are a banker thinking of lending money to Microsoft, you want Microsoft to have a low debt ratio because a smaller amount of other liabilities increases your chances of being repaid. If you are a Microsoft stockholder, you want a higher debt ratio because you want the company to add borrowed funds to your investment dollars to expand the business. Thus, there is some happy middle ground where the debt ratio is not too high for creditors but not too low for investors. The general rule of thumb across all industries is that debt ratios should be around

50%, but this benchmark varies widely from one industry to the next. By com-

parison, APPLE COMPUTER's 2002 debt ratio was 35.0%.

Current Ratio

An important concern about any company is its liquidity, or ability to pay its debts in the short run. If a firm can't meet its obligations in the short run, it may not survive to enjoy the long run. The most commonly used measure of liquidity is the current ratio, which is a compari- son of current assets (cash, receivables, and inventory) with current liabilities. Current ratio is computed by dividing total current assets by total current liabilities. For Microsoft, the current ratio is computed as follows:

Current Ratio: ??3.812

Historically, the rule of thumb has been that a current ratio below 2 suggests the possibil- ity of liquidity problems. However, advances in information technology have enabled compa- nies to be much more effective in minimizing the need to hold cash, inventories, and other $48,576 $12,744Current Assets

Current Liabilities$15,466

$67,646Total Liabilities

Total Assets

From an accounting standpoint, market efficiency relates to the usefulness of so-called "fundamental analysis." Funda- mental analysis is the practice of using financial data to cal- culate the underlying value of a firm and using this underlying value to identify over- and underpriced stocks. The notion of fundamental analysis is in conflict with market efficiency, be- cause the analysis works only if current stock prices do not fully reflect all available accounting information. For this rea- son, fundamental analysis frequently has been regarded with skepticism by academics. However, some research has sug- gested that accounting data may be useful in predicting fu- ture stock returns. Ou and Penman and Holthausen and Larcker

demonstrate that financial ratios derived from publicly avail-able financial statements can be used to successfully forecast

stock returns for the coming year. So contrary to what is ex- pected of an efficient stock market, it looks like you can use publicly available accounting data to make money in the U.S. stock market.

Sources:Jane A. Ou and Stephen H. Penman, "Fi-

nancial Statement Analysis and the Prediction of

Stock Returns," Journal of Accounting and Econom-

ics(November 1989): 295. Robert W. Holthausen and David F. Larcker, "The Pre- diction of Stock Returns Using Financial Statement

Information," Journal of Accounting and Economics

(June 1992): 373.

207Chapter 5Introduction to Financial Statement Analysis

Caution

The debt ratio is often confused with the

debt-to-equity ratio and the asset-to-equity ratio. Each of these ratios is a measure of a company's leverage. However, each is computed slightly differently. Make sure when discussing a leverage ratio, it is un- derstood which one is being used. liquidityA company's ability to pay its debts in the short run. current ratioA measure of the liquidity of a business; equal to current assets di- vided by current liabilities.

66885_c05_202-253.qxd 11/13/03 7:39 PM Page 207

current assets. As a result, current ratios for successful companies these days are frequently less than 1. Current ratios for selected U.S. companies are shown in Exhibit 4.

Return on Sales

As mentioned earlier, Microsoft makes 27.6 cents of profit on each dollar of sales. This ratio is called return on salesand, using Microsoft's numbers, is computed as follows:

Return on Sales: ??27.6%

As with all ratios, the return-on-sales value for Microsoft must be evaluated in light of the appropriate industry. For example, the 2001 return on sales for Microsoft was 29%. At the other end of the spectrum, return on sales in the supermarket industry is frequently between

1% and 2%. These values, because they come from outside Microsoft's industry, do not really

provide a useful benchmark against which Microsoft's return on sales can be compared. A bet- ter comparison for Microsoft is the 2002 return-on-sales value for Apple Computer, which was

1.1%. So, it appears that return on sales for Microsoft was substantially above the industry av-

erage in 2002; why this happened will be examined later in the chapter.

Asset Turnover

Microsoft's balance sheet reveals total assets of $67.646 billion. Are those assets being used ef- ficiently? A financial ratio that gives an overall measure of company efficiency is called asset turnoverand is computed as follows:

Asset Turnover: ??0.42

Microsoft's asset turnover ratio of 0.42 means that for each dollar of assets Microsoft is able to generate $0.42 in sales. The higher the asset turnover ratio, the more efficient the company is at using its assets to generate sales. In evalu- ating Microsoft's asset turnover, note that asset turnover for Apple Computer in

2002 was 0.91, indicating that Microsoft was less efficient than its competitor

at using its assets to generate sales.

Return on Equity

What investors really want to know is not how many pennies of profit are earned on a dollar of sales or what the current ratio is - they want to know how much $28,365 $67,646Sales

Total Assets$7,829

$28,365Net Income Sales

208Part 1Financial Reporting and the Accounting Cycle

Exhibit 4:Current Ratios for Selected U.S. Companies 2002

Coca-Cola 1.00

Delta Air Lines 0.60

Dow Chemical 1.32

McDonald's 0.71

Wal-Mart 0.93

return on salesA measure of the amount of profit earned per dollar of sales, computed by dividing net income by sales. asset turnoverA measure of company efficiency, com- puted by dividing sales by total assets.

Caution

The computed asset turnover ratio can be

misleading, as discussed in the concluding section of this chapter, because not all eco- nomic assets are recorded as assets on the balance sheet. Thus, the denominator of the ratio can be understated, sometimes very significantly.

66885_c05_202-253.qxd 11/13/03 7:39 PM Page 208

profit they earn for each dollar they invest. This amount, called return on equity, is the overall measure of the performance of a company. Return on equity for Microsoft is computed as follows:

Return on Equity: ??15.0%

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